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October 1998

Research
U P D AT E
f r o m t h e F e d e r a l R e s e r v e B a n k o f N e w Yo r k
RESEARCH AND MARKET ANALYSIS GROUP

What Course Should Capital Regulation Take
in the Next Century?
On February 26-27, 1998, bank supervisors,
researchers, and financial industry practitioners from more than fifteen countries gathered
at the Federal Reserve Bank of New York for
the conference “Financial
A conference hosted Services at the Crossroads:
Capital Regulation in the
by the Federal Reserve Bank Twenty-First Century.” The
conference, which was
held in partnership with
of New York considers strategies
the Bank of England, the
Bank of Japan, and the
for improving the current system Board of Governors of the
Federal Reserve System,
of bank capital standards. took stock of the existing
system of capital rules and
identified key objectives for the future development of capital regulation.
The proceedings of the conference, published in a special issue of the Bank’s
Economic Policy Review (vol. 4, no. 3),

include nineteen papers on a wide range of
topics—the impact of capital rules on bank
risk taking, industry approaches to monitoring risk, the role of capital regulation in bank
supervision, and proposals for reforming the
regulatory framework put in place by the
Basle Accord of 1988. Also included in the volume are speeches by Federal Reserve
Chairman Alan Greenspan, Deutsche
Bundesbank Board Member Edgar Meister,
and Tom de Swaan, who at the time of the
conference was the Chairman of the Basle
Committee on Banking Supervision and
Executive Director of De Nederlandsche Bank.
Conference participants expressed conflicting views on some issues, but a consensus did emerge on two important points.
First, participants agreed that the increasing
sophistication of financial institutions’ risk
management procedures requires corresponding refinements in supervisory prac-

New Research: July–September 1998

tice. Regulatory capital requirements, several
speakers noted, must evolve in line with
advances in industry methods of quantifying
risk and allocating capital. Second, there was
a shared perception that the growing specialization of financial institutions is making
“one-size-fits-all” capital requirements
increasingly ineffective. Participants suggested
that the existing structure of rules should be
modified to take into account the differing
risk profiles and characteristics of individual
institutions. Indeed, the difficulty of devising
uniform requirements for diverse institutions
led some speakers to predict that the regulatory
community would in the future move away

from specific rules toward a system of general
principles for prudent risk management.
Although the conference did not establish a
formal agenda for capital regulation in the
next century, it did outline the challenges that
will face supervisors and the financial industry in coming years. For financial institutions,
a key objective will be identifying the best
methods of measuring the various risks they
encounter—including credit, operational, and
legal risks. For supervisors, the central task
will be devising a regulatory framework that is
flexible enough to apply to the complex operations and rapidly changing risk exposures of
financial institutions.

Publications and Papers
The Research and Market Analysis Group produces a wide range of publications and
discussion papers:
• The Economic Policy Review—a policy-oriented research journal focusing
on macroeconomic, banking, and financial market topics.
http://www.ny.frb.org/rmaghome/econ_pol/1998.htm
• Current Issues in Economics and Finance—a newsletter-style publication offering
concise and timely analyses of economic and financial topics.
http://www.ny.frb.org/rmaghome/curr_iss/1998.htm
• Second District Highlights—a regional supplement to Current Issues covering financial
and economic developments in the Federal Reserve System’s Second District.
http://www.ny.frb.org/rmaghome/curr_iss/sec_dis
• Staff Reports—technical papers presenting research findings, designed to stimulate
discussion and elicit comments. These papers are intended for publication in leading
economic and finance journals. http://www.ny.frb.org/rmaghome/staff_rp/1998.htm
• Research Papers—discussion papers reporting preliminary research findings.
http://www.ny.frb.org/rmaghome/rsch_pap/1998.htm
• Publications & Other Research—a brochure spotlighting the Group’s research output
for the year. http://www.ny.frb.org/rmaghome/otherres

Fall in Bank Capital Ratios Linked to Bank Strategy
of Boosting Payouts to Shareholders
The sharp decline in U.S. bank holding companies’ capital ratios in 1997 largely reflected
efforts by the institutions to return earnings to
shareholders, according to Beverly Hirtle in
“Bank Holding Company Capital Ratios and
Shareholder Payouts” (Current Issues in
Economics and Finance, vol. 4, no. 9).
Hirtle explains that since the late 1980s
and early 1990s, bank holding companies
have greatly increased
their capital ratios—the
Average capital ratios fell
measures used by regulatory agencies to gauge
considerably in 1997, especially bank capital strength.
Although nearly all instituamong the largest banks. tions now have capital
ratios that comfortably
exceed the regulatory minimums, average
ratios did fall considerably in 1997, especially
among the largest banks.
Such drops “could cast doubt on these
institutions’ future capital strength,” Hirtle
notes, “particularly if their credit quality were
to deteriorate significantly or if profitability
were otherwise to weaken.” She adds that, in
the extreme, such capital constraints could
undermine banks’ ability to expand their
lending activities or participate fully in other
key financial services.
Hirtle assesses the seriousness of these
concerns by examining the reasons for 1997’s
fall in bank capital ratios. She concludes that
“concerns of this type may be premature,”
finding that the drop in average ratios is due
mainly to large banking companies’ strategy
of managing their capital positions by

returning earnings to shareholders, rather
than to an unusually large elevation in riskweighted exposures.
Following a period of strong, sustained
profitability, bank holding companies were
also found to have significantly increased
their payouts to shareholders in 1997, in the
form of dividend payments and stock repurchases. The author reveals that most of the
rise in payouts came from a surge in stock
repurchases. Significantly, banking companies can cut back on repurchases more easily
than they can reduce dividends if earnings
begin to fall. “Should the companies’ future
income deteriorate, the repurchases would
provide a large cushion before equity holdings
were affected,” says Hirtle.

Economists Win Award
for Best Article
Paolo Pesenti and Eric van Wincoop,
economists in our International Research
area, recently won the Hicks-Tinbergen
medal, awarded by the European
Economic Association for the best article
published in the European Economic
Review in the past two years. Their
paper—“Wages,
Profits,
and
the
International Portfolio Puzzle”—investigates the impact of fluctuations in the
return to human capital on the composition of international asset portfolios. The
paper was cowritten with Laura Bottazzi
of Bocconi University, Milan. See
European Economic Review 40, no. 2
(February 1996): 219-54.

Federal Reser ve Bank of New York

For Countries Coping with Unfair Foreign Competition,
Antidumping Tariffs Are a Questionable Remedy
As the international trade agreements of the
1990s weaken or eliminate many barriers to
trade, countries are increasingly resorting to
antidumping tariffs—tariffs imposed on
imports judged to be unfairly priced. In “Free
versus Fair Trade: The Dumping Issue”
(Current Issues in Economics and Finance,
vol. 4, no. 8), Thomas Klitgaard and Karen
Schiele examine the economics of antidumping actions and conclude that this form of
protection—both in concept and in application—is largely unsound.
Supporters of antidumping tariffs claim
that the tariffs prevent foreign producers from
radically underpricing their exports as part of
a scheme to drive domestic producers out of
business. Klitgaard and Schiele show that

countries have, in fact, little economic incentive to engage in such “predatory pricing.”
The authors also call into question the way
in which allegations of dumping are investigated. Pricing practices that are a normal
part of domestic commerce, they note, are
regarded as evidence of illegal behavior, and
the standard used to establish that domestic
industries have been injured by imports is
exceedingly weak.
The authors conclude their discussion by
pointing out that industries hurt by import
competition have alternative remedies—an
appeal to the antitrust authorities or a petition
for temporary relief under a so-called safeguard action.

The Earnings Gap in the New York–New Jersey Region
Parallels National Gap
Much has been written about the growing gap
in income between workers at the top and
bottom of the earnings distribution—a trend
that is evident across the United States. How
large is that gap in the New York–New Jersey
region, and how has it changed over the years?
In “Earnings Inequality: New York–New
Jersey Region,” David Brauer, Beethika Khan,
and Elizabeth Miranda review earnings
inequality over the 1979-96 period (Second
District Highlights, July). They find that in
1996, year-round, full-time male workers at
the top of the income spectrum earned about

five times what workers near the bottom
earned ($80,000 compared with $15,000, measured in 1996 dollars). In 1979, that gap in
earnings was much smaller: high-income
workers took home less than three and onehalf times as much as low-income workers
($63,700 compared with $19,000).
Although significant, the regional rise in
earnings inequality is not out of step with the
U.S. trend, report the authors. Both regionally
and nationally, income inequality has
widened about 50 percent in the past two
decades.

Structural Change in the Mortgage Market Leads to Greater
Refinancing Activity in the 1990s
In the past two decades, the home mortgage
market has undergone two major refinancing
episodes, first in 1986 and 1987 and then in
1992 and 1993. Although both episodes were
prompted by similarly steep declines in longterm interest rates, refinancing activity in the
1992-93 period was significantly more intense.
What explains the increased intensity of
refinancing in the 1990s? In “Structural
Change in the Mortgage Market and the
Propensity to Refinance,” Paul Bennett,
Richard Peach, and Stavros Peristiani use
duration analysis to show that a combination
of technological, regulatory, and structural
changes has lowered the explicit financial
transaction costs associated with obtaining a
mortgage (Staff Reports, no. 45). Points and
fees fell from 2.5 percent of the average
conventional loan amount in 1983 to about
1 percent at the end of 1995.
Lower transaction costs, however, cannot
explain all of the increase in refinancing
activity. Even after controlling for interest rate

differentials, points and fees, and other measurable costs, the authors find that refinancing
probabilities were considerably higher in the
1990s than in the 1980s. They attribute this
additional increase to developments that
may have reduced the nonfinancial costs of
refinancing a mortgage, including more
aggressive solicitations by lenders, the
streamlining of the refinancing application
and approval processes, and increased financial
sophistication among homeowners.

Electronic Alert Service
By subscribing to our free Electronic Alert
Service, you can automatically receive
e-mail notifications when new publications
and papers are available at our web site. You
can then go directly to the site and download
a publication or order the hard-copy version
electronically. Please visit the site for details.
http://www.ny.frb.org/rmaghome

Research Group Holds Intranational Macroeconomics
Conference
This summer, the Research and Market
Analysis Group hosted an Intranational
Macroeconomics Conference at the New York
Fed. The two-day conference was organized
in conjunction with the publication of
Intranational Macroeconomics, a book currently being coedited by Eric van Wincoop, an
economist in the Group’s International
Research area.

The conference drew thirty-five researchers
from universities in the United States and
Europe as well as economists in the Federal
Reserve System. Stephen G. Cecchetti,
Director of Research at the New York Fed,
delivered the opening remarks.
van Wincoop explains that intranational
macroeconomics, a relatively new field, has

Federal Reser ve Bank of New York

grown rapidly in recent years as economists
investigate what the interaction of regions
within a country can teach us about countries’
global interaction. The economic significance
of national borders, he adds, has been blurred
by such factors as the worldwide removal of
capital controls, the reduction of tariffs and
other trade barriers, and the adoption of a

single European currency. The papers presented
by the book’s contributing authors and the
ensuing discussions addressed the implications
of these and other factors for the future of the
world economy.
For more information, please contact
Mr. van Wincoop at eric.vanwincoop@ny.frb.org.

Recently Published
Richard Deitz.“A Joint Model of Residential and Employment Location in Urban Areas.” Journal of
Urban Economics 44, no. 2 (September): 197-215.
Erica Groshen.“Analyzing Firms,Workers, and Wages.” Monthly Labor Review 121, no. 7 (July): 54-5.
Sydney Ludvigson.“The Channel of Monetary Transmission to Demand: Evidence from the Market
for Automobile Credit.” Journal of Money, Credit, and Banking 30, no. 3 (August, Part 1): 365-83.
Carol Osler.“Short-Term Speculators and the Puzzling Behavior of Exchange Rates.” Journal of
International Economics 43, no. 1 (June): 37-58.
Sangkyun Park.“Can Credit Derivatives Be Widely Applied to Bank Loans?” ABA Banking Journal
90, no. 8 (August): 30-4.
Sangkyun Park and Stavros Peristiani.“Market Discipline by Thrift Depositors.” Journal of Money,
Credit, and Banking 30, no. 3 (August, Part 1): 347-64.
Eli Remolona and Rama Seth.“Modeling Foreign Bank Performance and Lending Behavior,” with
Philip Molyneux. Financial Markets, Institutions and Instruments 7, no. 4.
Robert Rich.“Disagreement as a Measure of Uncertainty: A Comment on Bomberger,” with J. S.
Butler. Journal of Money, Credit, and Banking 30, no. 3 (August, Part 1): 411-8.
Rama Seth.“Do Banks Follow Their Customers Abroad?” with Daniel E. Nolle and Sunil K. Mohanty.
Financial Markets, Institutions and Instruments 7, no. 4.
Egon ZakrajŠek.“The Importance of Credit for Macroeconomic Activity: Identification Through
Heterogeneity,” with Simon Gilchrist. In S. Brakman, H. van Ees, and S. K. Kuipers, eds., Market
Behaviour and Macroeconomic Modelling, 129-57. New York: St. Martin’s Press.

Papers Presented by Economists in the Research
and Market Analysis Group
Kenneth Kuttner. “Does Talk Matter After All?
Inflation Targeting and Central Bank
Behavior,” with Adam Posen. Implementation
of Price Stability Conference, Center for
Financial Studies, Johann Wolfgang University,
Frankfurt, September 11.
Looking at the experience of Canada, New
Zealand, and the United Kingdom after they
have adopted inflation targets, Kuttner and
Posen seek to discern changes in the way in
which central banks and financial markets
respond to inflation. They conclude that the
behavior of the banks and markets does appear
to change with the adoption of inflation targets,
but in ways that differ across the three countries.

Paolo Pesenti. “Paper Tigers? A Preliminary
Assessment of the Asian Crisis,” with Giancarlo
Corsetti and Nouriel Roubini. NBER International Macroeconomics and Finance Summer
Institute, Cambridge, Massachusetts, July 15.
The authors develop an interpretation of the
Asian meltdown that focuses on moral hazard
as the common source of overinvestment,
excessive external borrowing, and current
account deficits in the region. They present evidence supporting the thesis that weak cyclical
performances, low foreign exchange reserves,
and financial deficiencies resulting in high
shares of nonperforming loans were at the core
of the Asian crisis.

Sydney Ludvigson. “Can We Explain the
Consumption Excesses Yet? Aggregate
Consumption Implications of Buffer Stock
Saving Behavior,” with Alexander Michaelides.
NBER Aggregate Implications of Microeconomic Consumption Behavior Summer
Meeting, Cambridge, Massachusetts, July 21.
Ludvigson and Michaelides examine the
aggregate consumption implications of a
standard buffer stock model of precautionary
saving. They also investigate whether the
model can explain the well-known smoothness of aggregate consumption growth or its
correlation with lagged income. Ludvigson
and Michaelides find that although the
model partially explains the “consumption
excesses,” it does not match the data well in
magnitude: aggregate consumption growth is
determined to be both too volatile and too
highly correlated with lagged income.

Lawrence Radecki. “The Expanding Geographic Reach of Retail Banking Markets.”
Seminar sponsored by the Financial Markets
and Institutions Committee of the Antitrust
Section of the American Bar Association,
Washington, D.C., September 17.
Countering the prevailing view that competition in retail banking markets occurs in
local markets, Radecki argues that banking
competition has in recent years shifted to larger
geographic arenas. Radecki finds that many
banks set uniform rates for both retail loans
and deposits across an entire state or broad
regions of a large state. His analysis of the relationship between retail deposit rates and measures of market concentration provides further
evidence of an expansion in market size.
Individual copies of these papers can be
obtained by e-mailing the authors at
firstname.lastname@ny.frb.org.

Federal Reser ve Bank of New York

RESEARCH AND MARKET ANALYSIS GROUP
PUBLICATIONS AND PAPERS:
JULY–SEPTEMBER 1998
Economic Policy Review
Volume 4, Number 3
This issue is dedicated to the proceedings of the
February 26-27 conference “Financial Services at
the Crossroads: Capital Regulation in the TwentyFirst Century,” cosponsored by the Bank of
England, the Bank of Japan, the Board of Governors
of the Federal Reserve System, and the Federal
Reserve Bank of New York.

Current Issues in Economics
and Finance
Earnings Inequality: New York–New Jersey Region,
by David Brauer, Beethika Khan,
and Elizabeth Miranda
Volume 4, Number 7 (July)
Second District Highlights
Free versus Fair Trade: The Dumping Issue,
by Thomas Klitgaard and Karen Schiele
Volume 4, Number 8 (August)
Bank Holding Company Capital Ratios and
Shareholder Payouts, by Beverly Hirtle
Volume 4, Number 9 (September)

Staff Reports
Identifying Noise Traders: The Head-and-Shoulders
Pattern in U.S. Equities, by C.L. Osler
Number 42 (July)
Soft Exchange Rate Bands and Speculative Attacks:
Theory and Evidence from the ERM since August
1993, by Leonardo Bartolini and Alessandro Prati
Number 43 (August)
The Dual Nature of Trade: Measuring Its Impact
on Imitation and Growth, by Michelle P. Connolly
Number 44 (August)

Structural Change in the Mortgage Market and the
Propensity to Refinance, by Paul Bennett,
Richard Peach, and Stavros Peristiani
Number 45 (September)
International Trade and American Wages
in General Equilibrium, 1967-1995,
by James Harrigan
Number 46 (September)

Research Papers
What Inventory Behavior Tells Us about Business
Cycles, by Mark Bils and James A. Kahn
Number 9817 (July)
Does Exchange Rate Stability Increase Trade
and Capital Flows? by Philippe Bacchetta
and Eric van Wincoop
Number 9818 (July)
The Rise and Decline (?) of U.S. Internal Labor
Markets, by Erica L. Groshen and David I. Levine
Number 9819 (July)
Information Asymmetry, Market Segmentation,
and the Pricing of Cross-Listed Shares: Theory
and Evidence from Chinese A and B Shares,
by Sugato Chakravarty, Asani Sarkar, and Lifan Wu
Number 9820 (August)
How Important Is the Stock Market Effect
on Consumption? by Sydney Ludvigson
and Charles Steindel
Number 9821 (September)
Paper Tigers? A Model of the Asian Crisis,
by Giancarlo Corsetti, Paolo Pesenti,
and Nouriel Roubini
Number 9822 (September)

The views expressed in the publications and papers summarized in Research Update are those of the
authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the
Federal Reserve System.